The million pound pension problem

Surely, there’s no nicer problem to have than a million pound pension. Or to be specific, one that’s likely to exceed the UK’s £1,073,100 lifetime allowance, after which tax charges of up to 55 per cent apply.

This magic ceiling no longer rises with inflation. At the last Budget, chancellor Rishi Sunak froze the lifetime allowance (LTA) at this level for the next five years — a move expected to bring in nearly £1bn for the Treasury as more professionals are snared by it.

No one has much sympathy for “pension millionaires”, but the retirement income from a £1m pot is not enough to fund a millionaire lifestyle, and may not even make you a higher rate taxpayer. Plus, working out whether you will hit the LTA or not is quite a head scratcher.

Take my friend Rod, for instance. He recently celebrated his 60th birthday, which focused his thoughts on when he might retire (advisers say this is a common phenomenon).

So too is having quite a collection of pensions, including defined benefit (DB) — the most generous kind that pay a percentage of your final salary in retirement — and defined contribution (DC) — known also as money purchase, as you end up with a pot of money that you use to buy an annuity, or generate an investment income with.

Many people Rod’s age explore the pros and cons of cashing in a final salary pension, but he would rather have the security of regular income.

DB schemes are indifferent to market movements, but Rod was pleasantly surprised to see how his various DC pots had zonked up in value over the past year.

Great — but not so from a tax perspective, as he was now in danger of breaching the LTA.

The onus is on individuals to manage this in the run-up to retirement. That can be tricky if you have multiple pots, as different pension providers will not “test” your tax position until you start taking benefits, or hit your 75th birthday.

Advisers tell me their phone lines are buzzing with inquiries from people like Rod who require the help of a professional tax planner to work out how best to turn their assets into income as efficiently as possible. Sound familiar? Here are four questions to bear in mind.

What’s your retirement sequence?
Like Rod, most readers in their 50s and 60s are likely to have a combination of DB and DC pensions. Working out which benefits to take from which pension, and when, is a real puzzle.

David Hearne, a chartered financial planner who specialises in LTA issues, likes to use the visual metaphor of fitting rocks, pebbles and sand into a jar.

For most people Rod’s age, DB pensions are the biggest rocks. Hearne suggests starting with these.

The value of a DB pension is calculated as 20 times the annual income it generates, plus any tax-free cash. Rod is in line to receive £26,000 a year, plus a lump sum of £162,000, which would use up £682,000 of his lifetime allowance.

If he didn’t take a lump sum, his annual income would only be marginally higher at £28,000, using up £560,000 of his lifetime allowance.

Taking the tax-free cash might look like a no-brainer — but if Rod’s other DC pensions added up to more than £400,000, doing so would breach the £1.073m allowance.

“Once you know the percentage of your allowance that any DB pensions take up, you can calculate exactly what’s available for any DC pensions,” Hearne says, noting these “pebbles” can be tested and taken more flexibly to maximise the tax advantages.

Could it pay to delay?
At 60, Rod’s old enough to start taking his final salary pension, but intends to keep working. He doesn’t want to pay 40 per cent income tax taking a pension he doesn’t need when he might pay 20 per cent in later years.

Yet for every year he delays his retirement date, his annual pension increases in value, pushing him closer to the LTA.

“It’s all about working out the lesser of two evils,” says Hearne, adding that advisers will produce cash flow forecasts to illustrate the range of likely scenarios — and tax charges — that could result.

“When you’re making these kinds of decisions you need to be aware of tax, but you shouldn’t be entirely driven by it,” is his guidance.

Do you have a plan for your tax-free cash?
Just because you can take out a 25 per cent tax free lump sum from your various pensions doesn’t mean you automatically should.

“Inside your pension, that money is shielded from inheritance tax, dividend tax and capital gains tax,” says Michael Martin, head of 7IM’s private client business. Take out a big lump sum, and that money is immediately inside your estate.

“If you don’t spend it or give it away, it’s lying around waiting to be taxed, and at risk of slowly dying of inflation,” Martin says.

Assuming you don’t need the cash today, leaving it inside your pension could save your heirs from a 40 per cent inheritance tax charge if you died before the age of 75. This is a relatively recent quirk and there are fears a future chancellor could remove it.

So all the more reason to enjoy the money now? Rod dreams of buying a property on the coast that he could eventually retire to — but even here, there are tax consequences. Buying a second home before he sells his main residence would mean extra stamp duty, tax on any rental income and a potential IHT liability. By sticking with Airbnb for a few years, he could avoid these.

What if you’re not ready to retire?
If Rod keeps working, he can keep paying into his DC pension, benefiting from employer contributions and tax relief.

However, take more than just the tax-free cash from other DC pots and you risk falling into the tax trap of the MPAA (money purchase annual allowance) reducing your annual allowance from £40,000 to just £4,000 — for life.

Over a quarter of a million people triggered the MPAA under lockdown — but bizarrely, taking income from a DB pension makes no difference.

“If you have all of that, plus employment income, you’re unlikely to need to draw down any further taxable income from DC plans that would trigger the MPAA,” adds Hearne.

However, be aware that it’s not possible to place some older workplace DC schemes into drawdown arrangements once the tax-free cash is taken. You can move them into a Sipp, but Martin warns: “Watch out for early exit charges if you do this before your scheme’s normal retirement age, which could be 65.”

Pension freedoms were intended to give us more choice. In reality, they have made pensions so complicated that investing in some tax planning is a prerequisite for anyone heading towards the £1m mark.

Claer Barrett is the FT’s consumer editor: claer.barrett@ft.com; Twitter @Claerb; Instagram @Claerb